Structured note volumes may be rising, but its not all good news for structured note issuers in 2007. As the market has matured and investors have become ever more sophisticated, a two-speed market has evolved. Now, some dealers are predicting the end of the structured note market as we know it.

Accelerating away from the pack, investment banks have turned the MTN product from a debt-raising tool for borrowers into a humble wrapper for more exotic derivative sales. Left behind, many traditional issuers have found the door to cheap structured funding closed, and have had to turn back to the vanilla syndicated bond market.

"In the future, we will face a situation where almost all structures are done by dealers themselves, and by a very small number of issuers. They will be the ones who are number one in terms of pricing, flexibility and communications," warns Commerzbanks head of MTNs Amaury Gossé.

The sovereign, supranational and agency sector has been particularly hard hit. KfW has seen its structured issuance drop to around 10% of its funding, from nearly a quarter in previous years, for instance, while the European Investment Bank has also found conditions tougher.

Jean Erik de Zagon of the EIB says: "We have seen the market slow down for structured notes in general, and weve also some more complicated products, making it difficult to price  for instance notes with multiple correlations. We are noticing an apparent renewed accent on dealers selling their own names, and we also have the impression that investors are more willing to take risks on issuers further down the credit spectrum."

Two trends have combined to make life difficult for structured note issuers, says Gossé. First, the US investment banks have benefited from ratings upgrades and lower risk capital weightings over the last couple of years, making them more attractive for investors. Second, structures have become more complex and become based on a wider range of underlyings.

"Dealers have managed to get very good issuing and buyback conditions from their own treasuries," he says. "It makes life so much easier for everybody involved, in terms of flexibility, pricing and secondary markets."

Gossé says that the increasing amount of dealer self-led paper in the market is putting pressure on issuers to change their ways and puts it in stark terms. "The free lunch is over, and theyve taken some time to realise that. Its war out there: they have to fight their competitors, and now they have to fight the dealers."

Goldman Sachs head of MTNs, Marko Milos, agrees. "Trades are increasing in terms of complexity  issuers are not doing the same structured volume as in 2003 and 2004 because the investor base has moved on in terms of sophistication."

"There is a knowledge gap," says de Zagon at the EIB. "Product structurers on MTN desks have a vivid imagination and keeping pace with all the developments can be tricky."

Though dealers are often willing to help out EIB with its pricing process, it cannot always get to a stage where it is able to model the structure well enough to issue. "While we do like to work closely with dealers, sometimes there can be a conflict of interest  if dealers come up with an idea and wish to keep it proprietary, it doesnt help us."

Other dealers also point to the difficulty of getting support and realistic buyback levels from third party issuers. "There are significant constraints in a banks desire and appetite to provide secondary market support for third party issuer paper," says HSBCs global head of MTNs Chris Jones.

"For example, not only would a borrower charge a much more aggressive spread to do a new issue but theyd also impose significant costs if ever we were to ask for an unwind at any point during the life of the transaction, whereas making a secondary market in your own paper has zero restrictions. This issuer- imposed bid/offer creates deep dissatisfaction with the investor community."

Goldmans Milos thinks that many issuers are failing to recognise that the game has changed from 2004/2005 when large target redemption deals were being priced almost every day, and issuers could pick and choose the structures they wanted to print. "Ive been saying this for sometime but with the markets being as they are  if issuers who are focused on structured product dont keep up with the changed environment  I think we are fast heading towards a market where most structured products are being issued by dealers and the rest being third party borrowers who can keep up with the times."

However, many issuers are seeing the change, and attempting to move with the times  to varying degrees of success. Kara Lemont, head of interest rate derivatives at BNP Paribas, for instance, says that even supranationals are doing their best to stay on the cutting edge. "Issuers have been trying to adapt their models and their pricing capabilities as well to try and adapt to new products," she says. Despite engineering ever-more complex, hybrid asset class deals, she hasnt yet noticed a big problem in finding borrowers ready to issue.

"We havent had a huge problem Id say, except for in a couple of cases. There was one, a commodity-linked note where we had a hard time getting anyone to issue. But in terms of rates and equity products, we havent had any problem with issuers."

Gossé says that some issuers are becoming more flexible. "Were seeing issuers that in the past would just tell you their level, and that was that, to them now saying, Come back to me, maybe I can give you another basis point to get this trade done."

Its all about attitudes to structured funding, says Katherine Mitchell, head of MTNs at BNP Paribas in London. "Flexibility is key in this environment to get trades executed,"

But despite the best efforts of all involved, there is no doubting the figures that show an increasing number of self-led deals coming to market. And that means issuers increasingly have to find alternative funding sources.

"Issuers are having to pay up to do more vanilla business," says Milos. "They must choose between increased focus on structured trades, or paying up to do vanilla trades in bigger volume. It was the case last year and it is also the case now."

And Gossé predicts a shake-out to come. "In a few years time I think it will all be self-led with just a few sophisticated issuers. Theyll be no place for issuers in between."